Reasoning for status quo

MPC cannot ignore food inflation

The six-member Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) is meeting this week to review the policy. Several factors in the backdrop would be comforting for the committee. First is the commitment shown by the government to fiscal consolidation in the Budget, presented in July. The Union government will now target restricting the fiscal deficit to 4.9 per cent of gross domestic product (GDP), compared to 5.1 per cent projected in the Interim Budget, and is on course to contain the fiscal deficit below 4.5 per cent of GDP next year. This augurs well for inflation outcomes. Second, the core inflation rate is at about 3 per cent. Third, economic-growth momentum, as reflected in direct tax collection during the quarter gone by, seems intact.

However, despite some of these favourable factors, what is perhaps complicating the policy is elevated food inflation. The headline inflation rate in June was 5.08 per cent, while the food inflation rate was at 9.36 per cent. The higher food inflation rate is keeping the headline rate above the target of 4 per cent. The MPC expects the consumer price index (CPI)-based inflation rate to average 4.5 per cent this financial year. Given that the policy repo rate is at 6.5 per cent, some believe the real policy rate of 2 per cent is higher than what is required to bring the inflation rate down to the target. In fact, two external MPC members voted for a rate cut in the last meeting. Thus, it is worth debating whether the real policy rate is higher than required.

Recent research by RBI staff — though it does not reflect the official position of the central bank — showed that the natural rate of interest in the fourth quarter of 2023-24 was at 1.4-1.9 per cent, compared to 0.8-1.0 per cent in the third quarter of 2021-22. The natural rate of interest is broadly defined as the rate when savings are equal to investment, consistent with stable prices. The difference between the real policy rate and the natural rate indicates the policy stance. If the real rate is higher than the natural rate, the policy is considered restrictive and vice versa. Therefore, with an expected inflation rate of 4.5 per cent, the real rate can broadly be considered neutral taking into account the upper end of the natural rate range.

Further, the latest Economic Survey suggested that “... inflation targeting framework should consider targeting inflation, excluding food”. The underlying reasoning is that food inflation is often supply-induced. Short-run monetary tools are meant to address price pressure emanating from excess aggregate demand growth. However, as also noted by the Expert Committee to Revise and Strengthen the Monetary Policy Framework, which submitted its report in 2014, CPI-headline and CPI-food tend to drive changes in inflation expectations. Besides, it is the combined inflation that the consumer faces. Ignoring food from the framework can affect expectations and food inflation can quickly get generalised. Thus, a shift in focus will not be advisable. Further, given the new evidence on the natural rate of interest, it makes sense for the MPC to wait till the inflation rate gets closer to the target of 4 per cent on a durable basis. The recent flareup in West Asia has only increased risks.